March 21, 2010

Today's Links Worth Noting (with commentary)

Freddie Mac announces that (as of September) it will no longer support mortgages that provide an interest-only period. That's a good move. As one of the small lenders quoted inthe article comments, these products make sense, if at all, only for wealthy borrowers who have ample ability to increase payments when the monthly amounts "jump" at the end of the interest-only period (sometimes as long as 10 years); but they were offered to many who don't fall into that category. Note that the article indicates that the three-month delinquency rate on these types of mortgages that it holds is 18%--more than double the rate for principal & interest mortgages. That is not surprising, since such mortgages EITHER are just a silly incentive for taking out a loan without starting to pay it back immediately--silly, because Americans don't need incentives for more leverage but rather incentives to start paying down their debt-- OR operate under demonstrably false hypotheses such as the assumption that home values will go up sufficiently to pay off the loan in a quick sale (where the borrower is just "flipping" the house) or that the borrower who can only afford the initial interest payment now will make more money later so that paying higher interest AND a portion of the principal will be feasible later. Either way, they are one of among many "financial innovations" of the last few decades that primarily serve only to line the pockets of mortgage lenders while creating more instability in the financial system.

Hmmm. Given my various warnings about the harms of speculation, you can probably guess that I find the hypothesis here unable to stand up to much scrutiny. The journalist obviously was looking for a catchy attention-getter--how to make a hero out of the current bad guy. So while the article gives a little lip service to the real problems with naked market speculation, most of the time it is spent mouthing the encomiums that speculators have created about speculators to describe themselves as an important part of a functioning market. Bunk, I fear.

Here's why. Schwartz notes that the role of speculators in the recent financial system crash is "hotly debated" on Wall Street and in academe. He quotes a lone academic on the way speculators tend to increase market volatility by inflating bubbles on the way up and deflating them on the way down. Then he spends the rest of the article quoting short sellers and other speculative traders on their views of why speculation is an overall good--in fact, even mentioning (with a caveat that it may go too far) Edward Chancellor's view that speculation is driven by utopian views of an equal society rather than by greed. Ha, if only.

So he quotes a shortseller who says that because short sellers do market research to decide what to short, their trades aren't gambles. That's a false distinction. Research or no, trades are gambles. Only the initial investment in equity or debt is productive, in that it goes into the busienss and provides capital to buy equipment or raw materials or hire productive employees--all of the trading after that is a gamble of one sort or another. Naked trading in derivatives, of course, is even more clearly speculative gambling that just hopes to cash in on a perceived trend direction by voting with or against it. (Contrast with flash trading, using clients' expected buy-sell positions to make a profit, which isn't a gamble at all since it is an unfair way to make money off the market procedures themselves--neither productive in supplying capital to businesses nor helpful to investors in supplying information about investment possibilities but really a kind of insider trading taking advantage of known positions.) Even researched positions are not sure things--and even positions that seem fundamentally sound because a fundamental flaw in a company has been found can go wrong because the company addresses the flaw in time to come out.

The journalist "buys" that researched trades aren't gambles, and moves from that to state as fact that speculative trading "helps reduce risk by taking on the other side of popular trades, resisting the herd mentality that creates bubbles in the first place." Well, the fact is that for every trade there is someone in the opposite position. Speculators are as likely to be on the wrong side as the right side, where right is defined as the side that most accurately reflects economic fundamentals. One of the problems with the 2008 crisis was that there were lots of trades all assuming that house values were going to keep going up and therefore mortgage securities were going to keep being paid off. But they were made with insurance, which left the insurers holding the bag. In the credit default swap casino, AIG was the big holder of the losing chips (and, without the bailout, many of AIG's counterparties would have held losing chips as well, with the loss being diffused among all of those who had not stopped to consider that the hedge was only as good as the party providing it).

As for that idea that speculators act out of a utopian view of societal equity rather than greed, I'm gonna have to pass on that. Greed certainly seems to be the primary motivator in most, in the financial assets world where money and status and power are inextricably intertwined. Sure, part of the lure of any "get rich quick" scheme is that it allows the lowliest participant to have some possibility of being as rich as the wealthiest royalty. But the system really operates quite adversely to that view. Most of the riches accrue to those who already have them, or the financial institutions that manage the trades and get rich off of both sides, going up and coming down.

Dodd's letter to attorney general Holder is worth noting. He asks Holder to investigate the use of repo transactions as an accounting gimmick to hide information. As you will recall, the March 11 report from the bankrtupcty examiner in the Lehmann case (available on BNA for those with a subscription at a link from 47 DTR K-3 Mar 10, 2010) revealed the financial firm's teetering financial state had been hidden through a series of repo transactions designed to make its leger look less vulnerable by removing bad assets.

Repo transactions are really financings, but they can sometimes be treated as "true sales" for accounting purposes. This is one of the places where accounting should adopt tax standards rather than vice versa (in fact, there are lots of them). Tax has long required an examination of economic substance, and repo transactions are treated as financings. But accounting allows minor deviations from standard financing terms to treat repo transactions as "true sales" that thus disguise the amount of leverage on a firm's books or the fact that particular assets--in this case, bad mortgage loans--remain on the books. It's time that accountants quit playing so many gimmicks and adopted an economic substance standard.

Comments

Freddie Mac announces that (as of September) it will no longer support mortgages that provide an interest-only period. That's a good move. As one of the small lenders quoted inthe article comments, these products make sense, if at all, only for wealthy borrowers who have ample ability to increase payments when the monthly amounts "jump" at the end of the interest-only period (sometimes as long as 10 years); but they were offered to many who don't fall into that category. Note that the article indicates that the three-month delinquency rate on these types of mortgages that it holds is 18%--more than double the rate for principal & interest mortgages. That is not surprising, since such mortgages EITHER are just a silly incentive for taking out a loan without starting to pay it back immediately--silly, because Americans don't need incentives for more leverage but rather incentives to start paying down their debt-- OR operate under demonstrably false hypotheses such as the assumption that home values will go up sufficiently to pay off the loan in a quick sale (where the borrower is just "flipping" the house) or that the borrower who can only afford the initial interest payment now will make more money later so that paying higher interest AND a portion of the principal will be feasible later. Either way, they are one of among many "financial innovations" of the last few decades that primarily serve only to line the pockets of mortgage lenders while creating more instability in the financial system.

Hmmm. Given my various warnings about the harms of speculation, you can probably guess that I find the hypothesis here unable to stand up to much scrutiny. The journalist obviously was looking for a catchy attention-getter--how to make a hero out of the current bad guy. So while the article gives a little lip service to the real problems with naked market speculation, most of the time it is spent mouthing the encomiums that speculators have created about speculators to describe themselves as an important part of a functioning market. Bunk, I fear.

Here's why. Schwartz notes that the role of speculators in the recent financial system crash is "hotly debated" on Wall Street and in academe. He quotes a lone academic on the way speculators tend to increase market volatility by inflating bubbles on the way up and deflating them on the way down. Then he spends the rest of the article quoting short sellers and other speculative traders on their views of why speculation is an overall good--in fact, even mentioning (with a caveat that it may go too far) Edward Chancellor's view that speculation is driven by utopian views of an equal society rather than by greed. Ha, if only.

So he quotes a shortseller who says that because short sellers do market research to decide what to short, their trades aren't gambles. That's a false distinction. Research or no, trades are gambles. Only the initial investment in equity or debt is productive, in that it goes into the busienss and provides capital to buy equipment or raw materials or hire productive employees--all of the trading after that is a gamble of one sort or another. Naked trading in derivatives, of course, is even more clearly speculative gambling that just hopes to cash in on a perceived trend direction by voting with or against it. (Contrast with flash trading, using clients' expected buy-sell positions to make a profit, which isn't a gamble at all since it is an unfair way to make money off the market procedures themselves--neither productive in supplying capital to businesses nor helpful to investors in supplying information about investment possibilities but really a kind of insider trading taking advantage of known positions.) Even researched positions are not sure things--and even positions that seem fundamentally sound because a fundamental flaw in a company has been found can go wrong because the company addresses the flaw in time to come out.

The journalist "buys" that researched trades aren't gambles, and moves from that to state as fact that speculative trading "helps reduce risk by taking on the other side of popular trades, resisting the herd mentality that creates bubbles in the first place." Well, the fact is that for every trade there is someone in the opposite position. Speculators are as likely to be on the wrong side as the right side, where right is defined as the side that most accurately reflects economic fundamentals. One of the problems with the 2008 crisis was that there were lots of trades all assuming that house values were going to keep going up and therefore mortgage securities were going to keep being paid off. But they were made with insurance, which left the insurers holding the bag. In the credit default swap casino, AIG was the big holder of the losing chips (and, without the bailout, many of AIG's counterparties would have held losing chips as well, with the loss being diffused among all of those who had not stopped to consider that the hedge was only as good as the party providing it).

As for that idea that speculators act out of a utopian view of societal equity rather than greed, I'm gonna have to pass on that. Greed certainly seems to be the primary motivator in most, in the financial assets world where money and status and power are inextricably intertwined. Sure, part of the lure of any "get rich quick" scheme is that it allows the lowliest participant to have some possibility of being as rich as the wealthiest royalty. But the system really operates quite adversely to that view. Most of the riches accrue to those who already have them, or the financial institutions that manage the trades and get rich off of both sides, going up and coming down.

Dodd's letter to attorney general Holder is worth noting. He asks Holder to investigate the use of repo transactions as an accounting gimmick to hide information. As you will recall, the March 11 report from the bankrtupcty examiner in the Lehmann case (available on BNA for those with a subscription at a link from 47 DTR K-3 Mar 10, 2010) revealed the financial firm's teetering financial state had been hidden through a series of repo transactions designed to make its leger look less vulnerable by removing bad assets.

Repo transactions are really financings, but they can sometimes be treated as "true sales" for accounting purposes. This is one of the places where accounting should adopt tax standards rather than vice versa (in fact, there are lots of them). Tax has long required an examination of economic substance, and repo transactions are treated as financings. But accounting allows minor deviations from standard financing terms to treat repo transactions as "true sales" that thus disguise the amount of leverage on a firm's books or the fact that particular assets--in this case, bad mortgage loans--remain on the books. It's time that accountants quit playing so many gimmicks and adopted an economic substance standard.